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Monday, 14 September 2015

Why Keppel REIT and Office REIT are still not attractive

Came acrossS-REIT
Investment blog'swrite up on
Keppel REIT where its price has fallen to "attractive levels". While
the financial ratios do look attractive, it is only one side of the story and I
do not find Keppel REIT attractive yet.

Poor Office
outlook

According to
URA, there will be 545,000 square meters of new office space
available for 2016. And judging from the office space demand
during the past 5 years (2010-2014), the annual net demand is
110,000 square meters. Therefore, it is likely office space vacancy
will rise by approximately 400,000 square meter.Currently there is a vacancy rate of
9.8% (746,000 sq m vacant space vs total current supply of 7,583,000 sq m). In
2016, vacancy rates are likely to spike above 11%. The last time Singapore
experienced an office vacancy rate above 11% was during the GFC and 2001-2004
period.

Office Space Supply from URA

Furthermore,
this oversupply is set to persist because more office spaces will be built from
2017 to 2019 and across each of these years, annual supply is greater than
annual demand. Hence, in order to spur more companies to take up office spaces,
rental rates are likely to fall by 15-20% from current levels. Lastly, the
increase in office spaces are due to completion of new Grades A office
buildings such as Guocotower and Duo. Hence the argument that
Keppel or Capitacommercial are protected due to their quality grade A assets
does not stand.

What does a fall
in rental income mean?

Lower
Distributable Income

Lower rentals
mean less revenue and thus less profit. Hence, the current yield of 7.28% is
set to be lower when the full effects of an office supply glut kicks in. It is
worth noting majority of Keppel’s REIT tenancy contracts only expires in 2017
and after. Hence there will be a time lag in a profit fall because lower rental
rates for Keppel’s office space are likely to happen after 2017 when tenancy
contracts are renewed. Hence dividends are likely to be affected in the future.

Lower Valuation of properties

REITS tend to use the capitalisation methodology
to value their assets. The formula is simple:

Firstly, with property income being lower in the
future, Keppel’s property value will fall.

Secondly, cap rates for office spaces are likely
to increase. This is because a rise in global interest rates will increase the
cap rate. Also, a lack of growth in office space rental prices result in a
higher cap rate as well. In short, the impending rise in global interest rates
and lack of growth will increase the cap rates of office buildings.

With a fall in
property income and rise in cap rates, the value of such REITS office property
value are set to tumble. This can be seen in CapitaCommercial Trust’s (CCT)
presentation below where the cap rates of its buildings are lower than previous
years. Cap rates in some CCT assets are now creeping back to their old levels
of 4+%. This phenomenon will apply to Keppel REIT as well because their office
properties are similar to CCT.

CCT Capitalization Rates
Table

A lower
valuation of properties means a higher gearing ratio. This is because of the formula:

Gearing = Total Debt/ Total Asset

Hence for Keppel
REIT, with an impending fall in valuation, it means lower value for its assets
and hence a gearing ratio higher than its current 38.8%. This is not good
because MAS requires all REITS to maintain a gearing level of 45% to its total
assets. Should Keppel's gearing exceed 45%, it will have to raise money to pay
down its debts by placing out new shares or asking shareholders for money. This
will dilute the stakes of current shareholders and reduce dividend yield. The
alternative is to sell off its assets which also reduces dividend yield.

Keppel itself
does not have much cash in its reserves to pare down debts because it is
obligated to pay at least 90% of its cashflow as dividends. Furthermore, many
REITS pay only the interest and roll over the principal at the
end, commonly known as Bullet Loan.

Conclusion

To conclude,
given the impending fall in rental income due to a supply glut, Keppel REIT is
likely to be affected and its shareholders will experience lower
dividend yields. In addition, its NAV is likely to fall with lower
asset prices. Hence Keppel REIT's current price to book ratio is not reflective
of the actual situation.

This too may
be explain why CCT/OUE Commercial (another office REIT) are trading below its book
value and at a high trailing dividend yield. While Mapletree
commercial and Suntec have office properties, they have a significant exposure
to retail and are not as heavily weighted in office than Keppel and CCT/OUE.